Thematic Report

Paranoia pays

by NASSIM TALEB / Sep 10, 2018


In investing, finding the appropriate “dose” of risk is critical. “Too much will kill you, too little will not be effective,” explained Nassim Nicholas Taleb, eloquent advocate of a “real world” approach to financial risk, at last year’s CLSA Investors’ Forum in Hong Kong. He urged the audience to embrace paranoia, “because the best investment strategy is to love risk-taking while being paranoid.”

A former trader turned scholar and author, Taleb is an outspoken critic of established financial wisdom. His 2007 book, The Black Swan, introduced the phrase “black swan event” into common parlance, advocating preparedness for low-probability, high-impact events. Not surprisingly, Taleb was among the contrarians who profited from the 2008 financial crisis.

Listen to your elders
During his address, Taleb touched on several counterintuitive truisms that long-surviving traders are aware of. The first of which is that even if your strategy is to simply track an index, your returns will never match that of the market in the long run. That’s because in order to get the market return, “you have to constantly have the same amount of money in it,” pointed out Taleb, but external events – so-called “uncle points” – regularly force investors to either reduce their exposure or exit the game entirely.

Taleb’s latest book, Skin In the Game, warns of the folly of taking advice – investment or otherwise – from people who don’t stand to lose much if they are wrong. Instead of paying heed to behavioural finance theories that “make us feel irrational for buying protection” against unexpected, extreme events, Taleb suggested investors should instead “follow our grandmothers’ intuition,” noting that “science is catching up to confirm our grandmothers.”

The ruin problem
“If you want to succeed, you must first survive,” stressed Taleb, emphasising that “anything that has a small possibility of ruin will eventually lead to ruin.” In order to demonstrate the danger of basing strategy on averages, Taleb offered a thought experiment in which 100 people go to a casino and wager a set amount each. “Assume that gambler number 28 goes bust. Will gambler number 29 be affected? No,” he explained. Yet, if an individual goes to a casino 100 days in a row starting with a set amount and goes bust on day 28, “there is no day 29. That’s it. Kaput. This is known as the gambler’s ruin problem.”

Taleb critiqued several other tenets of portfolio theory and reprised his rejection of the normal distribution of returns, which he argues vastly underestimates the probability of crashes. “There’s a lot more uncertainty than you think in the world,” Taleb reiterated, but on the bright side, “there’s a lot of certainty about how you should act in the presence of uncertainty.”

Because people still don’t adequately gauge the tail risks, prices of options to hedge against them are typically low before blow ups, noted Taleb, and overshoot after crashes. Thus, not only is paranoia potentially lucrative, it’s generally cheap to boot.

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